DRAFT
Revenue Recognition and Service Contracts
A summary of the accounting rules applicable to Solicitors’ practices
25 April 2005
DRAFT
Revenue Recognition and Service Contracts
A summary of the accounting rules applicable to Solicitors’ practices
Introduction
In 1999 a guidance note was published by the Law Societies of England and Wales,
Scotland and Northern Ireland and agreed by the Inland Revenue following the
withdrawal of the cash basis (“the 1999 guidance”)1.
Section 42 of the Finance Act 1998 provides that the profits of a trade, profession or
vocation must be computed in accordance with generally accepted accounting
practice (GAAP). FRS 5 is an accounting standard of the Accounting Standards
Board and therefore forms part of GAAP. Firms of solicitors should therefore ensure
that their accounts comply with FRS 5.
There have been many developments in accounting standards since the 1999
guidance was agreed and published, the main one of concern to solicitors and which
will have an impact on the way that firms draw up their accounts and calculate the tax
due is the changes brought about by FRS 5 Application Note G: Revenue
Recognition, which was introduced on the 23 December 2003 and which affects all
firms which have an accounting period ending on or after that date.
This guidance note is not intended to be read in isolation as the promulgation of
accounting standards is the responsibility of the designated bodies such as the
Accounting Standards Board. The aim of this document is not to interpret the
accounting standards applicable to law firms but to highlight a number of issues for
firms to consider, particularly with regard to their contractual arrangements. We
strongly recommend that firms seek the advice of their accountants on the
interpretation of the relevant accounting standards and the practical implications
these standards have in relations to the firms’ accounts and therefore tax liabilities.
Background
In considering their accounting position, it is important for firms to have regard to all
the applicable accounting standards. The main ones of concern to solicitors are
Statement of Standard Accounting Practice 9 “Stocks and long-term contracts”
(“SSAP 9”), Financial Reporting Standard 5 (“FRS5”), and Application Note G to FRS
5 “Revenue Recognition” (“the application note”). These can be found in Appendix
A.
Many firms of solicitors have valued work in progress which has not been billed on
the basis of the lower of cost or net realisable value, therefore taking into account the
cost of their employees and overheads, but not including any time spent by partners
or any profit element of employees’ time. This practice has been justified on the
basis that the engagements in question are not long-term contracts as defined in
paragraph 22 of SSAP 9, or that if they are, the firms have taken the view that the
outcome of the contract cannot be “assessed with reasonable certainty” as required
by paragraph 10 of SSAP 9.
1
See appendix A
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SSAP 9
Long term contracts are defined in paragraph 22 of SSAP 9. A contract for a
combination of assets or services only those that 'constitute a single project' are
required to be accounted for as long-term contracts. Thus contracts that require
services to be provided on an ongoing basis rather than the provision of a single
service (or a number of services that constitute a single project) do not fall to be
accounted for as long-term contracts under SSAP 9. For example, a contract to
provide repetitive services (such as general professional advice, accounting support,
help desk support, maintenance or cleaning) on an ongoing basis should not be
accounted for as a long-term contract. 2
FRS 5
Paragraph 1 of FRS 5 provides that,
“The objective of this FRS is to ensure that the commercial effect of an entity’s
transactions is reported in its financial statements. The commercial effect of
the entity’s transactions, and any resulting assets, liabilities, gains or losses,
should be faithfully represented in its financial statements.”
To that end, paragraph 14 of FRS 5 requires that
“A reporting entity’s financial statements should report the substance of the
transactions into which it has entered. In determining the substance of a
transaction, all its aspects and implications should be identified and greater
weight given to those more likely to have a commercial effect in practice. A
group or series of transactions that achieves or is designed to achieve an
overall commercial effect should be viewed as a whole.”
Paragraph 46 of FRS 5 explains the general principle as follows,
“Paragraph 14 of the FRS sets out general principles for reporting the
substance of a transaction. Particularly for more complex transactions, it will
not be sufficient merely to record the transaction’s legal form, as to do so may
not adequately express the commercial effect of the arrangements.
Notwithstanding this caveat, the FRS is not intended to affect the legal
characterisation of a transaction, or to change the situation at law achieved by
the parties to it.”
The basic approach to identifying assets is set out in paragraph 16 of FRS 5,
“To determine the substance of a transaction it is necessary to identify whether
the transaction has given rise to new assets or liabilities for the reporting entity
and whether it has changed the entity’s existing assets or liabilities.”
“Assets” are defined by paragraph 2 to mean
“Rights or other access to future economic benefits controlled by an entity as a
result of past transactions or events.”
2
Paragraphs 11 and 12 of Abstract 40 “Revenue recognition and service contracts”
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“Control” in the context of an asset is also defined as,
“the ability to obtain the future economic benefits relating to an asset and to
restrict the access of others to those benefits.”
These provisions are summarised and explained in paragraphs 53 and 54 of FRS5
as follows,
“In accounting terms, the substance of a transaction is portrayed through the
assets and liabilities, including contingent assets and liabilities, resulting from or
altered by the transaction…
The definition of an asset requires that access to future economic benefits is
controlled by the entity. Access to future economic benefits will normally rest
on a foundation of legal rights, although legally enforceable rights are not
essential to secure access. Control is the means by which the entity ensures
that the benefits accrue to itself and not to others.”
FRS 5 therefore requires an entity’s financial statements to report the substance of
the transactions into which it has entered.
Application Note G
In order to assist an entity in complying with FRS 5 there are a number of Application
Notes dealing with the application of FRS 5 to transactions with certain features.
Application Note G is the latest in the series and provides guidance as to when an
entity is required to recognise revenue in its accounts. The Application Note is
consistent with, and does not amend, the requirements of SSAP 93.
There are two separate elements to the manner in which revenue should be treated
in an entity’s accounts under Application Note G. The first element is that the entity
must determine whether to recognise an increase in its assets (or a decrease in its
liabilities) at all. The second element is to measure the value to be attributed in the
accounts to that increase in assets (or decrease in liabilities).
Recognition
The basic principles of recognition are set out in paragraphs G4 - G6 of the
Application Note:
“G4 A seller recognises revenue under an exchange transaction with a
customer, when, and to the extent that, it obtains the right to consideration
in exchange for its performance. At the same time, it typically recognises
a new asset, usually a debtor.
G5
3
When a seller receives payment from a customer in advance of
performance, it recognises a liability equal to the amount received,
representing its obligation under the contract. When the seller obtains the
right to consideration through its performance, that liability is reduced and
Abstract 40 “Revenue recognition and service contracts”, paragraph 9
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the amount of the reduction in the liability is simultaneously reported as
revenue.
G6
A seller may obtain a right to consideration when some, but not all, of its
contractual obligations have been fulfilled. Where a seller has partially
performed its contractual obligations, it recognises revenue to the extent
that it has obtained the right to consideration through its performance.”
Paragraph G3 of the Application Note provides a number of definitions which are of
assistance in determining the meaning of the above principles:
“Performance
The fulfilment of the seller’s contractual obligations to a customer through the
supply of goods and services.
Right to consideration
A seller’s right to the amount received or receivable in exchange for its
performance. This right does not necessarily correspond to amounts falling
due in accordance with a schedule of payments which may be specified in a
contractual arrangement. Whilst stage payments will often be time to coincide
with performance, they may not correspond exactly. Stage payments reflect
only the agreed timing of payment, whereas a right to consideration arises
through the seller’s performance.”
The Application Note’s basic approach to recognition is plainly founded upon the
principles of contract law. This reflects the statement in FRS 5 that in normal cases,
the substance of a transaction, and a party’s access to future economic benefits, are
founded upon legal rights.
Measurement
Paragraph G7 of Application Note G specifies that the amount at which the revenue
should be included in the solicitor’s accounts is to be determined by measuring the
fair value of the right to the consideration.
Paragraph G3 of the Application Note defines ‘fair value’ as:“The amount at which goods or services could be exchanged in an arm’s length
transaction between informed and willing parties, other than in a forced or
liquidation sale.”
Paragraph G7 indicates that subject to specific rules for dealing with the time value of
money (paragraph G8) and credit risks/bad debts (paragraph G9) or other evidence
to the contrary,
“the fair value of the right to consideration will normally be the price specified in
the contract, net of discounts, VAT and similar sales taxes.”
UITF guidance
Following publication of the application note, questions arose about the accounting
for revenue (i.e. turnover) from contracts to provide services, and the UITF was
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asked to provide guidance on how the relevant accounting standards FRS 5
Application Note G and SSAP 9 should be applied in respect of contracts for services
that are not accounted for as long-term contracts.
On 10 March 2005 the UITF published Abstract 40 “Revenue recognition and service
contracts” (the Abstract”), giving guidance on the recognition of turnover derived from
contracts for professional and other services. The main point at issue was when the
applicable accounting literature requires or allows revenue to be recognised as
contract activity progresses or on contract completion. The Abstract confirms that
the term “accounted for as a long-term contract” refers to the method described in
SSAP 9 of recognising revenue as contract activity progresses.
The Abstract will take effect for accounting periods ending on or after 22 June 2005,
although earlier adoption of the abstract is encouraged. This Abstract applies to all
contracts for services.
Specific points to note
Paragraph 4 of the Abstract rightly acknowledges that the contract terms and
commercial substance of contracts vary considerably in practice. These variations in
contracts would naturally occur from entity to entity but will also arise within an entity.
This would certainly be true of most solicitors’ practices, especially those which deal
with many different types of work and client and therefore would have a range of
different contractual arrangements to meet those clients’ respective needs. As is
made clear in the abstract it is important for firms to “develop an appropriate
accounting policy having regard to the requirements of this Abstract, Application Note
G and SSAP 9” and apply it consistently to all similar contracts and from year to year.
The Abstract confirms that “SSAP 9 provides specific guidance on the accounting
treatment of long-term contracts. It requires turnover (and related costs) to be
recorded in the profit and loss account as contract activity progresses (paragraph
28). Turnover is ascertained in a manner appropriate to the stage of completion of
the contract, the business and the industry in which it operates.”
The Abstract confirms that Application Note G is consistent with, and does not
amend, the requirements of SSAP 9. It goes on to say that:
“The definition [of a long term contract] is clear that, in the case of contracts for
assets, only those for 'a single substantial asset' are required to be accounted
for as long-term contracts. Similarly, in the case of a contract for a combination
of assets or services only those that 'constitute a single project' are required to
be accounted for as long-term contracts.”4
The Abstract provides helpful clarification of the treatment of general ongoing advice:
“.. contracts that require services to be provided on an ongoing basis rather
than the provision of a single service (or a number of services that constitute a
single project) do not fall to be accounted for as long-term contracts under
SSAP 9. For example, a contract to provide repetitive services (such as
general professional advice…) on an ongoing basis should not be accounted
for as a long-term contract.”5
4
5
Paragraph 11 of the Abstract
Paragraph 12 of the Abstract
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The Abstract confirms that
“The overriding consideration is whether the seller has performed, or partially
performed, its contractual obligations. If it has performed some, but not all, of
its contractual obligations, it is required to recognise revenue to the extent that it
has obtained the right to consideration through its performance.6
The Abstract goes on to describe how to deal with situations where contractual
obligations are performed gradually over time. In such cases, revenue is
recognised to reflect the accrual of the right to consideration as contract activity
progresses.7 However, it is rightly recognised that
“Where the substance of a contract is that a right to consideration does not
arise until the occurrence of a critical event, revenue is not recognised until that
event occurs. This only applies where the right to consideration is conditional
or contingent on a specified future event or outcome, the occurrence of which is
outside the control of the seller.”8
Practical Examples of accounting treatment for Solicitors
We recognise that solicitors may be unfamiliar with accounting standards and their
implications. To assist solicitors we have set out some practical examples to
illustrate how the accounting standards may apply to different situations a firm may
experience. We stress that this is no substitute for proper accounting advice.
Example 1
A solicitor is retained to provide advice and documentation in relation to a noncontentious matter expected to last several months on the basis of an agreed hourly
rate, with chargeable units of 10 minutes. It is further agreed between the client and
solicitor that the solicitor will render a bill on the 10 of each month9. The solicitor’s
accounting period ends on the 5 April.
In order to comply with Application Note G the solicitor must recognise the revenue
arising from the hours which he has worked for that client between 11 March and 5
April in his accounts, even though he has not billed the client for them by 5 April. The
fact that the solicitor has provided the client with an estimate of the likely total cost of
the matter will not change this position.
The reason for this is that under the contract with the client, the solicitor fulfils his
contractual obligations by working, and his right to further consideration arises as
each time unit is worked. The fact that the solicitor had no right to demand payment
until after he had rendered a bill in accordance with the agreed billing schedule is
immaterial.10 The same analysis would follow if the solicitor had made no express
6
Paragraph 16 of the Abstract
Paragraph 18 of the Abstract
8 Paragraph 19 of the Abstract
9 The solicitor will also have provided the client with an estimate of the likely time and cost of
the work to be undertaken on the client’s behalf.
10 In respect to solicitors who undertake legal aid work this example should form the basis of
their revenue recognition. The amount which they recognise will have to be calculated either
upon an hourly rate or upon a proportion of the total cost of the matter. It will not be sufficient
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arrangement with the client as to when he would render his bills: he could not delay
recognition by omitting to send a bill until after 5 April.
Contrast that with a second example:Example 2
A solicitor is engaged on 11 March to produce a draft contract for an anticipated
transaction for a fixed fee on the basis that the draft will be produced by 10 April, and
it is agreed that the solicitor will not be entitled to charge the agreed fee unless the
draft contract is produced by that date. The draft is only finalised and delivered on 7
April.
In this case, Application Note G does not require the solicitor to account for any
revenue in his accounts drawn up to 5 April, because at the reporting date he had no
right to receive any consideration under his retainer. This will be so even though the
solicitor may have carried out most of the necessary research and the bulk of the
drafting work between 11 March and 5 April.
Example 3
A solicitor is retained under a conditional fee agreement in the form of Appendix 2 to
the “Payment by Results” booklet, under which in the event of the client winning his
claim, the basic charges and a success fee of 50% of the basic charges are payable.
If the client loses no charges or success fee are payable
Assuming that the retainer is not a long-term contract as defined by SSAP 9, then the
Application Note would not require either the basic charges of the solicitor or the 50%
success fee to be recognised unless and until the solicitor obtains the right to receive
it when the client wins his case. Until that point, the satisfaction of the contractual
provision is subject to the discretion of the judge in making an order. No matter how
confident the solicitor might be as to the outcome of the case, we see no reason,
whether by reference to the “substance” of the matter or a “commercial” approach, to
require the solicitor to produce accounts on a basis that does not accord with the
strict legal position.
There is the possibility of the client receiving judgment in his favour in one accounting
period but the costs of the matter not being assessed until a new accounting period
has begun. The standard Conditional Fee Agreement makes plain that upon the
client being successful he will be required to pay his solicitors their basic charges,
disbursements and a success fee. Therefore upon receiving judgment in his client’s
favour a solicitor must recognise the revenue, as provided by the contract, which was
contingent upon that result.11
for them to recognise only the standard monthly payments which they receive.
11 We attach a copy of the Conditional Fee Agreement upon which these comments are
based. Any risk of default in payment is relevant to measurement, not recognition.
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